Theory of Supply: Product Market

Theory of Production and Marginal Product

The Product Function

Production refers to the transformation of inputs into
outputs (or products)
An input is a resource that a firm uses in its production
process for the purpose of creating a good or service
A production function indicates the highest output (Q)
that a firm can produce for every specified combinations
of inputs ( physical relationship between inputs and
output), while holding technology constant at some
predetermined state
Mathematically, we represent a firms production function
as:
Assume that the firm produces only one type of output with
two inputs, labor (L) and capital (K)

The Product Function

The quantity of output is a function of, or depend

on, the quantity labor and capital used in production
Output refers to the number of units of the
commodity produced
Labor refers to the number of workers employed
Capital refers to the amount of the equipment used
in production
We assume that all units of L and K are
homogeneous or identical
Technology is assumed to remain constant during
the period of analysis

Production Theory
The Production Function in the Short Run

The Short Run

The short run is a time period where at
least one factor of production is in
fixed supply. A business has chosen its
scale of production and must stick with this
in the short run
We assume that the quantity of plant and
machinery is fixed and that production can
be altered by changing variable inputs
such as labor, raw materials and energy.

Total, Average and Marginal

Products
Total product (or total output). In manufacturing
industries such as motor vehicles and DVD
players, it is straightforward to measure how
much output is being produced. But in service or
knowledge industries, where output is less
tangible it is harder to measure productivity.
Average product measures output per-workeremployed or output-per-unit of capital.
Marginal product is the change in output from
increasing the number of workers used by one
person, or by adding one more machine to the
production process in the short run.

Law of Diminishing Returns

In the short run, the law of diminishing
returns states that as we add more units
of a variable input to fixed amounts of
land and capital, the change in total
output will at first rise and then fall.
Diminishing returns to labor occurs
when marginal product of labor starts to
fall. This means that total output will be
increasing at a decreasing rate.

Law of Diminishing Returns

Production Theory
The Production Function in the Long Run

Long Run Returns to Scale

In the long run, all factors of production
are variable. How the output of a
business responds to a change in factor
inputs is called returns to scale.

Long Run Returns to Scale

Long Run Return to Scale

When we double the factor inputs from (150L + 20K) to
(300L + 40K) then the percentage change in output is 150%
- there are increasing returns to scale.
When the scale of production is changed from (600L +
80K0 to (750L + 100K) then the percentage change in
output (13%) is less than the change in inputs (25%)
implying a situation of decreasing returns to scale.
Increasing returns to scale occur when the % change in
output > % change in inputs
Decreasing returns to scale occur when the % change in
output < % change in inputs
Constant returns to scale occur when the % change in
output = % change in inputs